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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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[x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2004
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___________ to ___________
Commission file number: 1-5721
LEUCADIA NATIONAL CORPORATION
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(Exact Name of Registrant as Specified in its Charter)
New York 13-2615557
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
315 Park Avenue South
New York, New York 10010
(212) 460-1900
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(Address, Including Zip Code, and Telephone Number, Including Area Code,
of Registrant's Principal Executive Offices)
Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange
Title of Each Class on Which Registered
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Common Shares, par value $1 per share New York Stock Exchange
Pacific Exchange, Inc.
7-3/4% Senior Notes due August 15, 2013 New York Stock Exchange
8-1/4% Senior Subordinated Notes due New York Stock Exchange
June 15, 2005
7-7/8% Senior Subordinated Notes due New York Stock Exchange
October 15, 2006
Securities registered pursuant to Section 12(g) of the Act:
None.
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(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statement
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K [ ].
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [x] No [ ]
Aggregate market value of the voting stock of the registrant held by
non-affiliates of the registrant at June 30, 2004 (computed by reference to the
last reported closing sale price of the Common Shares on the New York Stock
Exchange on such date): $2,575,756,000.
On March 4, 2005, the registrant had outstanding 107,613,828 Common Shares.
DOCUMENTS INCORPORATED BY REFERENCE:
Certain portions of the registrant's definitive proxy statement pursuant to
Regulation 14A of the Securities Exchange Act of 1934 in connection with the
2005 annual meeting of shareholders of the registrant are incorporated by
reference into Part III of this Report.
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PART I
Item 1. Business.
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The Company
The Company is a diversified holding company engaged in a variety of
businesses, including telecommunications, healthcare services, manufacturing,
banking and lending, real estate activities, winery operations, development of a
copper mine and property and casualty reinsurance. The Company concentrates on
return on investment and cash flow to maximize long-term shareholder value.
Additionally, the Company continuously evaluates the retention and disposition
of its existing operations and investigates possible acquisitions of new
businesses in order to maximize shareholder value. In identifying possible
acquisitions, the Company tends to seek assets and companies that are troubled
or out of favor and, as a result, are selling substantially below the values the
Company believes to be present.
Shareholders' equity has grown from a deficit of $7,700,000 at December
31, 1978 (prior to the acquisition of a controlling interest in the Company by
the Company's Chairman and President), to a positive shareholders' equity of
$2,258,700,000 at December 31, 2004, equal to a book value per common share of
the Company (a "common share") of negative $.07 at December 31, 1978 and $20.99
at December 31, 2004. The December 31, 2004 shareholders' equity and book value
per share amounts have been reduced by the $811,900,000 special cash dividend
paid in 1999.
In November 2003, pursuant to a registered exchange offer and merger
agreement, the Company acquired the balance of the outstanding common stock of
WilTel Communications Group, Inc. ("WilTel") that it did not already own for
16,734,690 of the Company's common shares. The Company had previously acquired
47.4% of the outstanding common stock of WilTel during 2002 for cash
consideration of $353,900,000, including expenses. WilTel is a
telecommunications company that owns or leases and operates a nationwide
inter-city fiber-optic network providing Internet, data, voice and video
services. Upon completion of the exchange offer and merger, WilTel became a
consolidated subsidiary of the Company.
SBC Communications Inc. ("SBC"), a major communications provider in the
U.S., is WilTel's largest customer, accounting for 70% of the Network segment's
2004 operating revenues. On January 31, 2005, SBC announced that it would buy
AT&T Corp., and announced its intention to migrate the services provided by
WilTel to the AT&T network. For more information about SBC see Item 1,
"Business-Telecommunications" below.
The Company's healthcare services operations are conducted by
subsidiaries of Symphony Health Services, LLC ("Symphony"), which was acquired
in September 2003. Symphony is engaged in the provision of physical,
occupational, speech and respiratory therapy services, healthcare staffing
services and Medicare consulting services.
The Company's manufacturing operations manufacture and market lightweight
plastic netting used for a variety of purposes including, among other things,
building and construction, erosion control, agriculture, packaging, carpet
padding, filtration and consumer products. In February 2005, the manufacturing
segment increased its product offerings and customer base though the purchase of
the assets of NSW, LLC U.S. ("NSW") for approximately $28,000,000.
2
The Company's banking and lending operations have historically consisted
of making instalment loans to niche markets primarily funded by customer banking
deposits insured by the Federal Deposit Insurance Corporation (the "FDIC").
However, as a result of increased loss experience and declining profitability,
the Company stopped originating subprime automobile loans in September 2001 and
all other consumer loans in January 2003. During 2004, the Company sold 97% of
its remaining outstanding loans to a third party for aggregate cash proceeds of
$149,000,000. Current operating activities at this segment are concentrated on
maximizing returns on its investment portfolio, collecting and servicing its
remaining loan portfolios and discharging deposit liabilities as they come due.
The Company's banking and lending subsidiary intends to ultimately surrender its
national bank charter.
The Company's domestic real estate operations include a mixture of
commercial properties, residential land development projects and other
unimproved land, all in various stages of development and all available for
sale.
The Company's winery operations consist of Pine Ridge Winery in Napa
Valley, California and Archery Summit in the Willamette Valley of Oregon. These
wineries primarily produce and sell wines in the luxury segment of the premium
table wine market.
The Company's copper mine development operations consist of its 72.1%
interest in MK Resources Company ("MK Resources") (formerly MK Gold Company), a
public company traded on the NASD OTC Bulletin Board (Symbol: MKRR).
The Company's property and casualty reinsurance business is conducted
through its 19% common stock interest in Olympus Re Holdings, Ltd. ("Olympus"),
a Bermuda reinsurance company primarily engaged in the property excess, marine
and aviation reinsurance business.
Certain of the Company's subsidiaries have substantial tax loss
carryforwards. The amount and availability of the tax loss carryforwards are
subject to certain qualifications, limitations and uncertainties as more fully
discussed in Note 15 of "Notes to the Consolidated Financial Statements" and
Item 7, "Management's Discussion and Analysis of Financial Condition and Results
of Operations."
On December 31, 2004, the Company effected a three-for-two stock split of
the Company's common shares in the form of a 50% stock dividend (the "Stock
Split"). The stock dividend was paid to holders of record of the Company's
common shares at the close of business on December 23, 2004. All amounts in this
Report have been adjusted to give retroactive effect to the Stock Split.
As used herein, the term "Company" refers to Leucadia National
Corporation, a New York corporation organized in 1968, and its subsidiaries,
except as the context otherwise may require.
Investor Information
The Company is subject to the informational requirements of the
Securities Exchange Act of 1934 (the "Exchange Act"). Accordingly, the Company
files periodic reports, proxy statements and other information with the
Securities and Exchange Commission (the "SEC"). Such reports, proxy statements
and other information may be obtained by visiting the Public Reference Room of
the SEC at 450 Fifth Street, NW, Washington, D.C. 20549 or by calling the SEC at
1-800-SEC-0330. In addition, the SEC maintains an Internet site
(http://www.sec.gov) that contains reports, proxy and information statements and
other information regarding the Company and other issuers that file
electronically. In addition, material filed by the Company can be inspected at
the offices of the New York Stock Exchange, Inc. (the "NYSE"), 20 Broad Street,
New York, NY 10005 and the Pacific Exchange, Inc., 115 Sansome Street, San
Francisco, CA 94104, on which the Company's common shares are listed. The
Company has submitted to the NYSE a certificate of the Chief Executive Officer
of the Company, dated May 11, 2004, certifying that he is not aware of any
violations by the Company of NYSE corporate governance listing standards.
The Company's website address is http://www.leucadia.com. The Company
makes available, without charge, through its website copies of its annual report
on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Exchange Act, as soon as reasonably practicable after such reports
are filed with or furnished to the SEC.
3
Financial Information about Segments
The Company's reportable segments consist of its operating units, which
offer different products and services and are managed separately. The Company's
telecommunications business is conducted by WilTel and contains two segments,
Network and Vyvx. Network owns or leases and operates a nationwide fiber optic
network over which it provides a variety of telecommunications services. Vyvx
transmits audio and video programming over the network and distributes
advertising media in physical and electronic form. The Company's other segments
include healthcare services, manufacturing, banking and lending and domestic
real estate. Healthcare services include the provision of physical,
occupational, speech and respiratory therapy services, healthcare staffing
services and Medicare consulting services. Manufacturing operations manufacture
and market lightweight plastic netting used for a variety of purposes. Banking
and lending operations historically made collateralized personal automobile
instalment loans to individuals who had difficulty obtaining credit, at interest
rates above those charged to individuals with good credit histories. The banking
and lending segment has ceased originating any new loans and in 2004 sold 97% of
its remaining outstanding loans to a third party. The Company's domestic real
estate operations consist of a variety of commercial properties, residential
land development projects and other unimproved land, all in various stages of
development and all available for sale. Other operations primarily consist of
winery operations and development of a copper mine.
Associated companies include equity interests in entities that the
Company accounts for on the equity method of accounting. Prior to the
acquisition of the outstanding common stock of WilTel that it did not already
own in November 2003, the Company accounted for its 47.4% interest in WilTel as
an associated company. Other investments in associated companies include
Olympus, a Bermuda-based reinsurance company, Berkadia LLC ("Berkadia"), a joint
venture formed to facilitate the chapter 11 restructuring of The FINOVA Group
Inc. ("FINOVA"), HomeFed Corporation ("HomeFed"), a corporation engaged in real
estate activities, Jefferies Partners Opportunity Fund II, LLC ("JPOF II") and
EagleRock Capital Partners (QP), LP ("EagleRock"). Both JPOF II and EagleRock
are engaged in investing and/or securities transactions activities.
Corporate assets primarily consist of investments and cash and cash
equivalents and corporate revenues primarily consist of investment income and
securities gains and losses. Corporate assets, revenues, overhead expenses and
interest expense are not allocated to the operating units. The Company has a
manufacturing facility located in Belgium and an interest, through MK Resources,
in a copper deposit in Spain. WilTel owns or has the right to use certain cable
systems which connect its U.S. domestic network to foreign countries, and has
the right to use wavelengths in Europe which it is currently not using. These
are the only entities with non-U.S. revenues or assets that the Company
consolidates, and they are not material. In addition to its investment in
Bermuda-based Olympus, the Company also owns 36% of the electric utility in
Barbados. From time to time the Company invests in the securities of non-U.S.
entities or in investment partnerships that invest in non-U.S. securities.
Except for the telecommunications segments of WilTel, the primary measure
of segment operating results and profitability used by the Company is income
(loss) from continuing operations before income taxes, minority expense of trust
preferred securities and equity in income (losses) of associated companies. For
WilTel's segments, segment profit from operations is the primary performance
measure of segment operating results and profitability. WilTel defines segment
profit from operations as income before income taxes, interest expense,
investment income, depreciation and amortization expense and other non-operating
income and expense.
The following information reconciles segment profit from operations of
the Network and Vyvx segments to the most comparable measure under accounting
principles generally accepted in the United States ("GAAP"), which is used for
all other reportable segments, for the year ended December 31, 2004 and for the
period from November 6, 2003 through December 31, 2003 (in millions):
4
For the period from
For the year ended November 6, 2003 to
December 31, 2004 December 31, 2003
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Network Vyvx Network Vyvx
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Segment profit from operations (1) $ 117.8 $ 30.3 $ 13.3 $ 4.1
Depreciation and amortization expense (197.4) (9.1) (37.2) (2.0)
Interest expense, net of investment income (2) (26.0) (2.1) (4.0) (.1)
Other non-operating income, net (2) 27.2 2.7 1.8 .5
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Income (loss) from continuing operations before
income taxes, minority expense of trust preferred
securities and equity in income (losses) of
associated companies (3) $ (78.4) $ 21.8 $ (26.1) $ 2.5
========= ======= ======== =======
(1) See note (d) to segment information below.
(2) If items in these categories cannot be directly attributed to a particular
WilTel segment, they are allocated to each segment based upon a formula
that considers each segment's revenues, property and equipment and
headcount.
(3) For 2004, includes income of $18,500,000 related to the settlement of
litigation for less than amounts reserved, income of $6,000,000 related to
the sale of an equity security which had a zero book value, gains of
$3,500,000 related to cash and securities received in excess of the book
value of secured claims in customers' bankruptcies and income of $2,300,000
related to the reversal of excess reserves for long-term commitments.
5
Certain information concerning the Company's segments for 2004, 2003 and
2002 is presented in the following table. Consolidated subsidiaries are
reflected as of the date of acquisition, which for WilTel's segments was
November 2003 and for Symphony's healthcare services segment was September 2003.
Associated Companies are only reflected in the table below under identifiable
assets employed.
2004 2003 2002
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(In millions)
Revenues and other income (a):
Network (b) $ 1,518.9 $ 218.4 $ --
Vyvx 123.6 21.2 --
Healthcare Services 258.4 71.1 --
Banking and Lending 30.8 62.3 95.9
Manufacturing 64.4 54.1 51.0
Domestic Real Estate 63.5 50.4 47.2
Other Operations 40.0 33.3 45.8
Corporate (c) 180.9 42.5 (4.7)
Intersegment elimination (d) (18.4) (4.3) --
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Total consolidated revenues and other income $ 2,262.1 $ 549.0 $ 235.2
========= ========= ========
Income (loss) from continuing operations before income taxes, minority expense
of trust preferred securities and equity in income of associated companies:
Network (d) $ (78.4) $ (26.1) $ --
Vyvx (d) 21.8 2.5 --
Healthcare Services 5.1 (2.3) --
Banking and Lending 22.0 8.4 1.9
Manufacturing 7.9 4.4 3.1
Domestic Real Estate 20.7 18.1 16.3
Other Operations (3.4) .7 14.5
Corporate (c) 59.6 (37.5) (74.9)
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Total consolidated income (loss) from continuing operations before
income taxes, minority expense of trust preferred
securities and equity in income of associated companies $ 55.3 $ (31.8) $ (39.1)
========= ========= ========
Identifiable assets employed:
Network $ 1,554.4 $ 1,628.8 $ --
Vyvx 57.3 115.5 --
Healthcare Services 65.6 54.6 --
Banking and Lending 151.1 252.4 481.5
Manufacturing 50.4 50.8 51.5
Domestic Real Estate 148.6 165.0 106.8
Other Operations 252.6 253.4 193.7
Investments in Associated Companies:
WilTel -- -- 340.6
Other Associated Companies 460.8 430.9 397.1
Corporate 2,059.6 1,445.8 970.6
--------- --------- --------
Total consolidated assets $ 4,800.4 $ 4,397.2 $2,541.8
========= ========= ========
6
(a) Revenues and other income for each segment include amounts for services
rendered and products sold, as well as segment reported amounts classified
as investment and other income and net securities gains (losses) on the
Company's consolidated statements of operations.
(b) For 2004 and the period from November 6, 2003 (date of acquisition) through
December 31, 2003, includes services provided to SBC of $1,032,800,000 and
$141,700,000, respectively.
(c) Net securities gains for Corporate aggregated $123,100,000 during 2004,
which primarily resulted from the sale of publicly traded debt and equity
securities that had been classified as available for sale securities. For
2004, includes a provision of $4,600,000 to write down investments in
certain available for sale securities. For 2003, includes a provision of
$6,500,000 to write down investments in certain available for sale
securities and an investment in a non-public security. For 2002, includes a
provision of $37,100,000 to write down investments in certain available for
sale securities and an equity investment in a non-public fund. The write
down of the available for sale securities resulted from a decline in market
value determined to be other than temporary.
(d) Eliminates intersegment revenues billed from Network to Vyvx. However, the
intersegment revenues are included in the calculation to determine segment
profit from operations and income (loss) from continuing operations for
each of Network and Vyvx.
(e) For the years ended December 31, 2004, 2003 and 2002, income (loss) from
continuing operations has been reduced by depreciation and amortization
expenses of $235,900,000, $61,400,000 and $18,500,000, respectively; such
amounts are primarily comprised of Corporate ($11,400,000, $11,700,000 and
$8,700,000, respectively), and amounts related to WilTel's segments, which
are disclosed above. Depreciation and amortization expenses for other
segments are not material.
(f) For the years ended December 31, 2004, 2003 and 2002, income (loss) from
continuing operations has been reduced by interest expense of $96,800,000,
$43,000,000 and $33,000,000, respectively; such amounts are primarily
comprised of Corporate ($55,300,000, $26,000,000 and $13,100,000,
respectively), banking and lending ($2,700,000, $8,800,000 and $18,100,000,
respectively), and amounts related to WilTel's segments, which are
disclosed above. Interest expense for other segments is not material.
At December 31, 2004, the Company and its consolidated subsidiaries had
5,324 full-time employees.
Telecommunications
Acquisition
During the fourth quarter of 2002, the Company acquired 47.4% of the
outstanding common stock of WilTel for an aggregate cash purchase price of
$353,900,000, including expenses. In November 2003, the Company consummated an
exchange offer and merger pursuant to which WilTel became a wholly-owned
subsidiary of the Company and former WilTel public stockholders received an
aggregate of 16,734,690 common shares of the Company. The aggregate purchase
price for the 2003 acquisition was approximately $425,300,000, consisting of
$422,800,000 of the Company's common shares (based on a price of $25.27 per
share) and cash expenses of $2,500,000. Following completion of the merger, the
Company consolidated the financial condition and results of operations of
WilTel, and no longer accounts for its investment in WilTel under the equity
method of accounting. In the aggregate, the Company invested $779,200,000 in
cash and common shares issued to acquire 100% of WilTel during 2002 and 2003. At
December 31, 2004, the Company's consolidated balance sheet includes total
WilTel assets of $1,611,700,000 and total WilTel liabilities of $1,118,300,000
(which are non-recourse to the Company), resulting in a net investment of
$493,400,000.
Certain telecommunications terms used throughout this section are defined
under "Telecommunications Glossary" below.
7
Network
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Business Description
Through its Network segment, WilTel owns or leases and operates a
nationwide inter-city fiber-optic network. WilTel has also built a fiber-optic
network within certain cities in the U.S. and has the ability to connect to
networks outside the U.S. Network provides Internet, data, voice, and video
services to companies that use high-capacity and high-speed telecommunications
in their businesses. Network sells its products to the wholesale carrier and
enterprise market segments, and many of its most significant customers provide
retail telecommunications services to consumers and businesses. Historically,
Network's fastest growing and largest revenue component is its voice business.
Network also offers rights of use in dark fiber, which is fiber that it
installs but for which it does not provide communications transmission services.
Purchasers of dark fiber rights install their own electrical and optical
transmission equipment. Network also provides space and power to collocation
customers at network centers and a variety of professional and managed services
including network design and construction, network management and network
monitoring or surveillance.
WilTel's network includes ownership interests in or rights to use:
- nearly 30,000 miles of fiber-optic cable in the U.S., of which
27,677 is currently in service;
- local fiber-optic cable networks within 40 of the largest U.S.
cities;
- 118 network centers located in 107 U.S. cities;
- fiber-optic cable connecting the U.S. and Mexico in California and
Texas, and the U.S. and Canada in Washington, Illinois and New
York;
- capacity on five major undersea cable systems connecting the
continental U.S. with Europe, Asia, Australia, New Zealand, Guam
and Hawaii; and
- rights to use wavelengths in Europe connecting the UK, France,
Germany, Belgium, the Netherlands, Norway, Denmark, Finland, and
Sweden. These rights have been exercised and wavelengths are
available but not currently in use.
Properties
U.S. Inter-City Network
Miles In Average Number of
The WilTel Network Route Miles Operation Fibers Per Cable
------------------ ----------- --------- -----------------
Wholly owned fiber routes, built by WilTel 18,027 17,416 123
Fiber routes through dark fiber rights (1) 10,884 10,261 17
------ ------
Total 28,911 27,677
====== ======
(1) Network has obtained rights in dark fiber and conduits of approximately
10,884 route miles, all of which have had fiber-optic cable installed.
Network manages the transmission equipment on the routes it acquired,
and it typically pays for the maintenance of fiber-optic strands and
rights of way.
Network also leases capacity from both long-distance and local
telecommunications carriers, including its competitors, in order to meet the
needs of its customers. Leases of capacity are distinguished from rights in dark
fiber in that capacity leases are for only a portion of the fiber capacity and
the lessor supplies and operates the equipment to transmit over the fiber.
Capacity leases are generally for terms of one month to five years, but can be
longer. Network leases from third parties approximately one percent of its U.S.
network capacity currently in use. These leases are for areas where Network does
not have its own network capacity, or such capacity is not currently sufficient
to meet the expected demand.
8
WilTel commenced construction of its network in 1997, began providing
services in 1998 and had substantially completed construction in 2002. The
domestic voice network grew to 25 switches as of December 31, 2004, including
twenty three domestic switches, four of which are Voice over Internet Protocol
capable, and two gateway switches. The gateway switches offer foreign
termination and inbound domestic termination to other carrier customers.
Conduit and fiber-optic cable. The WilTel network contains multiple
conduits along more than 90% of the routes it constructed. When constructing
fiber-optic cable, the manufacturer places fiber-optic strands inside small
plastic tubes, wraps bundles of these tubes with plastic, and strengthens them
with metal. Network then places these bundles inside a conduit, which is
high-density polyethylene hollow tubing one-and-one-half to two inches in
diameter. The conduit is generally buried approximately 42 inches underground
along pipeline or other rights of way corridors. Network also uses steel casing
in high-risk areas, including railroad crossings and high-population areas,
thereby providing greater protection for the cable. The first conduit generally
contains a cable that has between 96 and 144 fibers, and the second conduit or,
where constructed, a third conduit, serves as a spare. The spare conduits allow
for future technology upgrades, potential conduit sales, and expansion of
capacity. Network generally plans to retain from 8 to 24 fibers throughout the
network for its own use, with the remainder made available for leases of dark
fiber.
Rights of way. The WilTel network was primarily constructed by digging
trenches along rights of way, or rights to use the property of others, which
Network obtained throughout the United States from various landowners.
Generally, where feasible, Network used the rights of way of pipeline companies
that WilTel believed provided greater physical protection of the fiber system
and resulted in lower construction costs than systems built over more public
rights of way. Almost all of WilTel's rights of way extend through at least
2018. Rights of way are generally for terms of at least 20 years, and most cover
distances of less than one mile.
Local Network
As of December 31, 2004, Network was providing services on local networks
in 40 U.S. cities. These cities are: Anaheim, CA; Atlanta, GA; Bakersfield, CA;
Baltimore, MD; Boston, MA; Buffalo, NY; Chicago, IL; Columbus, OH; Dallas, TX;
Denver, CO; Fresno, CA; Houston, TX; Indianapolis, IN; Jersey City, NJ; Kansas
City, KS; Laredo, TX; Los Angeles, CA; McAllen, TX; Modesto, CA; Miami, FL;
Milwaukee, WI; Minneapolis, MN; New York, NY; Newark, NJ; Oakland, CA;
Philadelphia, PA; Phoenix, AZ; Portland, OR; Riverside, CA; Sacramento, CA; San
Francisco, CA; San Jose, CA; Santa Clara, CA; Seattle, WA; Secaucus, NJ; St.
Louis, MO; Stamford, CT; Tucson, AZ; Tulsa, OK; and Washington, D.C. WilTel also
has rights to utilize 30,740 local dark fiber miles in the U.S. through a fiber
lease agreement with AboveNet Communications, Inc. ("AboveNet"). In addition,
WilTel has the right to lease an additional 54,324 of dark fiber miles anywhere
that AboveNet may construct or currently owns dark fiber in the U.S. or Europe.
Products and Services
Network's principal products and services are as follows:
Packet-based data products. These services provide connections for
Internet, data, voice, and video networks at variable capacities between two or
more points. Specific packet-based data products include ATM, Frame Relay,
Ethernet Transparent LAN, Internet Protocol ("IP") transport and IP virtual
private networks. These services are billed on a flat rate or usage basis.
9
Private line products. Network provides customers with fixed amounts of
point-to-point capacity at various speeds on a protected or unprotected service
level. A protected service level provides restoration on the customer's circuit
under a variety of network outage conditions and is priced higher than
unprotected service. These services are billed as fixed monthly fees, regardless
of usage.
Voice services. Network provides wholesale origination, transport and
termination, as well as calling card, directory assistance, operator assistance,
toll-free services and international termination to more than 200 countries.
Optical wave services. This service is a point-to-point service which has
no protection capacity, and which allows a customer the exclusive use of a
portion of the transmission capacity of a fiber-optic strand rather than the
entire fiber strand. A purchaser of optical wave services installs its own
electrical interface, switching and routing equipment.
Backhaul services. Network has interconnected international cable landing
stations on the West and East Coasts with fiber-optic rings capable of
terminating cable traffic at specified Network centers. These services are made
available to customers that have access to their own undersea cables and require
domestic interconnection services only. Network also owns capacity positions on
five major undersea cable systems.
Customers
Network offers services to both carrier and enterprise markets, and its
customers currently include Regional Bell Operating Companies, ("RBOCs") cable
television companies, Internet service providers, application service providers,
data storage service providers, managed network service providers, digital
subscriber line service providers, long distance carriers, local service
providers, utilities, governmental entities, educational institutions, financial
institutions, international carriers and other communications services providers
who desire high-capacity and high-speed products on a carrier services basis.
SBC
Sales to SBC accounted for 70% of Network's 2004 operating revenues. On
January 31, 2005, SBC announced that it would buy AT&T Corp., and announced its
intention to migrate the services provided by WilTel to the AT&T network. SBC
indicated that it expects to close its acquisition of AT&T in the first half of
2006.
Once SBC completes the migration of its business from WilTel's network to
the AT&T network and terminates the existing preferred provider agreements
between WilTel and SBC (scheduled to extend until 2019), SBC will be required to
pay WilTel up to $200,000,000 for all costs WilTel incurs in connection with
such termination, including increased costs of the network facilities remaining
with WilTel due to the loss of SBC traffic (defined as "Transition Costs" in the
provider agreements). WilTel anticipates that a migration of services from its
network to AT&T would not begin until after the appropriate regulatory agencies
approve SBC's acquisition of AT&T. WilTel expects it will take anywhere from two
to three years from now for SBC to migrate all of its traffic off of WilTel's
network, and anticipates that it will continue to provide some level of service
to SBC into 2007.
Pursuant to the preferred provider agreements, the price for products and
services, determined separately for each product or service, generally will be
equal to the lesser of the cost of the product or service plus a specified rate
of return, the prices charged to other customers, the current market rate or, in
some circumstances, a specific rate. If either party can secure lower prices for
comparable services that the other party will not match, then that party is free
to utilize the lowest cost provider. WilTel and SBC have agreed to use a fixed
price for voice transport services (the substantial majority of WilTel's SBC
generated revenue) through April 1, 2005.
10
WilTel is currently engaged in negotiations with SBC with respect to a
transition pricing agreement and other matters that will enable WilTel to
continue to provide SBC with a high level of service after April 1, 2005. If the
parties fail to reach agreement on pricing, any disputes as to pricing
methodology are to be resolved through binding arbitration. The Company is also
evaluating the impact of SBC's intended acquisition of AT&T on WilTel's
operations and financial condition, including the potential adverse impact on
the carrying values of Network's assets. Under GAAP, the SBC announcement is
considered to be an event requiring the Company to assess the recoverability of
Network's assets (principally property and equipment) during the first quarter
of 2005. For more information about the process the Company expects to use to
assess the recoverability of Network's assets, see Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
WilTel plans to modify its operations in light of the anticipated loss of
its major customer, including expanding its customer base and evaluating
opportunities for consolidation. WilTel expects it will evaluate and implement
cost reduction strategies, investigate sales of assets and minimize capital
expenditure outlays to help offset the loss of SBC's business. However, given
the current economic condition of the telecommunications industry as a whole,
where telecommunications capacity far exceeds actual demand and the marketplace
is characterized by fierce price competition, and the limited growth of non-SBC
business over the past few years, WilTel does not believe it will be able to
fully replace the revenues and profits generated by the SBC agreements in the
near future, if ever. The Company believes there may be opportunities to
increase Network's value through consolidation opportunities, and it is actively
investigating those possibilities. However, no assurance can be given that the
Company will be successful in these efforts.
Sales and Marketing
Network's sales and marketing organizations target customers that require
high volumes of bandwidth to operate their businesses. The successful
acquisition of a new customer requires a high degree of technical knowledge
about both the product being sold and the customer's operation, since most of
Network's products need to be specifically configured to meet the unique needs
of each customer.
Network has a centralized marketing organization that has established a
segment-wide approach to marketing and product management. The marketing
organization is responsible for advanced market planning and segmentation,
product planning and development, product marketing, advertising, lifecycle
management, product economics, pricing and competitive analysis.
11
Competition
The telecommunications industry is highly competitive. Some of Network's
competitors may have financial, personnel and other resources significantly
greater than those of Network. In the market for carrier customers, Network
competes primarily with AT&T, MCI, Sprint, Qwest, Level 3, Global Crossing and
Broadwing. In the market for enterprise customers, Network competes primarily
with AT&T, MCI, and Sprint. Many of these competitors have revenues and customer
bases far larger than those of Network. Network also competes with numerous
other service providers that focus either on a specific product or set of
products or within a geographic region. Network competes primarily on the basis
of price, network reliability, customer service and support. Network's services
within local markets in the U.S. face additional competitors, including the
traditional regional telephone companies and other local telephone companies.
The telecommunications industry has experienced a great deal of
instability during the past several years. During the 1990s, forecasts of very
high levels of future demand brought a significant number of new entrants and
new capital investments into the industry. However, many industry participants
have gone through bankruptcy, those forecasts have not materialized,
telecommunications capacity now far exceeds actual demand and the resulting
marketplace is characterized by fierce price competition as competitors seek to
secure market share. Resulting lower prices have eroded margins and have kept
many in the industry from attaining positive cash flow from operations. In
addition, many larger industry participants (SBC, Verizon and Sprint) have
announced agreements to acquire other industry participants in transactions that
may further intensify the competitive environment. The Company does not know if
and when the current pricing environment will improve or achieve stability.
Vyvx
- ----
Business Description
Vyvx transmits audio and video programming for its customers over
Network's fiber-optic network and via satellite. It uses Network's fiber-optic
network to carry many live traditional broadcast and cable television events
from the site of the event to the network control centers of the broadcasters of
the event. These events include live sporting events of the major professional
sports leagues, including the last sixteen Super Bowls. For live events where
the location is not known in advance, such as breaking news stories in remote
locations, Vyvx provides an integrated satellite and fiber-optic network based
service to transmit the content to its customers. Most of Vyvx's customers for
these services contract for the service on an event-by-event basis; however,
Vyvx has some customers who have purchased a dedicated point-to-point service
which enables these customers to transmit programming at any time.
Vyvx also distributes advertising spots to radio and television stations
throughout the U.S., both electronically and in physical form. Customers for
these services can utilize a network-based method for aggregating, managing,
storing and distributing content for content owners and rights holders.
Products and Services
Vyvx's primary products and services are as follows:
Fiber Optic and Satellite Video Transport Services. Vyvx offers various
products to provide audio and video feeds over fiber or satellite for broadcast
and production customers. These products vary in capacity provided, frequency of
use (i.e., may be provided on an occasional or dedicated basis) and price. In
2004, Super Bowl XXXVIII was the first live broadcast event ever carried using
Vyvx's new high definition (HD) transport product.
12
Advertising Distribution Services. These services include:
Audio Distribution. Vyvx sends radio spots to stations via
electronic and physical distribution. Spots are distributed to over 10,500
stations in North America via the Internet using no proprietary hardware.
Video Distribution. Vyvx has the capability to deliver video
content electronically and physically to television stations, broadcast networks
and cable networks across the United States. Its electronic reach covers more
than 1,450 destinations.
Storage. Vyvx offers secure storage of media components in Vyvx's
climate-controlled storage facilities located in Burbank, Chicago and Newark,
Delaware.
Customers
Vyvx sells to media content service providers and businesses that use
media content as a component of their business. It does not compete with its
media customers for retail end-users. It has approximately 2,000 customers,
including major broadcast and cable television networks, news services,
professional and collegiate sports organizations, advertising agencies and their
advertisers, television companies and movie production companies. Approximately
62% of Vyvx's 2004 operating revenue was derived from its top 10 customers. Fox
Entertainment Group, Inc. and its parent company The News Corporation Limited,
through their various news, sports and entertainment businesses, accounted for
approximately 18% of Vyvx's operating revenues and TimeWarner, Inc. accounted
for 16% of Vyvx's operating revenues.
Sales and Marketing
Vyvx has sales personnel located in eight states and the District of
Columbia to provide service to its domestic and international customers. The
largest sales offices are in New York, New York and Burbank, California, where
many of Vyvx's largest customers are based.
Competition
The Company believes that no single competitor currently exists that
offers all of the services being offered by Vyvx. Vyvx encounters smaller
competitors in the market place, each of which historically has offered only one
or two of Vyvx's products.
13
Telecommunications Glossary
- ---------------------------
Access - a long distance carriers use of local exchange facilities to originate
or terminate long distance traffic or of leased lines for dedicated facilities.
Asynchronous transfer mode (ATM) - a Layer 2 high-speed multiplexing and
switching protocol that uses fixed cell sizes of 53 bytes each to transport
voice, data and video traffic.
Bandwidth - the width of or measure of capacity of a communications channel;
analog channel capacity is measured in hertz and digital channel capacity is
measured in bits per second.
Capacity - the information carrying ability of a telecommunications facility.
The facility determines what measure is appropriate. For example, a private
line's capacity could be measured in bits per second. A switch's capacity could
be measured in the maximum number of calls per hour.
Carrier - a provider of communications transmission services.
Carrier class customer - a customer who has significant bandwidth capacity
requirements that would rival the capacity requirements of a wholesale carrier.
Dark fiber - installed fiber-optic cable which is not connected to transmission
equipment and so is not capable of carrying transmission services.
Ethernet - a local area network used for connecting computers, printers,
workstations, terminal, servers, etc. within the same building or campus.
Ethernet Transparent LAN - a network with Ethernet interfaces that can carry any
Layer 3 protocol, giving the LANs it connects the appearance of complete
transparency, as though they were connected directly across an Ethernet cable.
Fiber-optic cable - a transmission medium consisting of a core of glass or
plastic which is surrounded by a protective cladding, strengthening material and
an outer jacket. Signals are transmitted as light pulses, introduced into the
fiber by a light transmitter (a light emitting diode or a laser). Low data loss,
high-speed transmission, large bandwidth, small physical size, light weight and
freedom from electromagnetic interference and grounding problems are some of the
advantages offered by fiber-optic cable.
Frame Relay - a Layer 2 switching and multiplexing protocol that places data in
frames of varying size and allows transmission of data with efficient error
correction.
Gateway switch - a switch that allows signals to cross from one network to
another.
High Definition (HD) - a system standard for transmitting a TV signal with far
greater resolution.
Internet Protocol (IP) - the Layer 3 communications protocol standard used for
delivering individual data packets to their destinations by tracking the
Internet addresses of the sender and receiver.
Layer 2 - a data communications standard (such as ATM, Frame Relay, or Ethernet)
that establishes a fixed, pre-determined path for the data stream. In the event
of a network outage, the switches work together to re-route traffic to
facilities not impacted by the outage.
Layer 3 - a data communications standard (such as IP) that does not create a
fixed path through the network, but makes an individual routing decision for
each data packet received based upon real-time updates of network congestion.
Because of this additional computation burden, Layer 3 networks tend to have
more latency that is less predictable, but are also less susceptible to major
network outages.
Local area network (LAN) - a data communications network that links together
computers and peripherals to serve users within a confined area.
Multiplexing - consolidation of multiple signals into a single, higher speed
signal that is transmitted to a receiver. The receiver then decomposes the
signal into its original constituent elements.
Network center - an environmentally controlled secure location containing
equipment and staff, and space and power for collocation customers, where
various network management and control functions are conducted.
Optical wave - see "Wavelengths" below.
Switch - mechanical or electronic device for making, breaking or changing the
directional flow of electrical or optical signals.
Transmission - sending electrical signals that carry information over a physical
path to a destination.
14
Virtual private network (VPN) - private, secure switched voice or data network
between two or more sites that functions as a dedicated or private line facility
while using public network segments.
Voice over IP - telephone calls using IP.
Wavelengths - a portion of the transmission capacity of a fiber-optic cable
rather than the entire fiber cable. A purchaser of optical wave or wavelength
installs its own electrical interface, switching and routing equipment.
Government Regulation
- ---------------------
Overview
WilTel is subject to significant federal, state, local and foreign laws,
regulations and orders that affect the rates, terms and conditions of certain of
its service offerings, its costs and other aspects of its operations. Regulation
of the telecommunications industry varies from state to state and from country
to country, and it changes regularly in response to technological developments,
competition, government policies and judicial proceedings. Some of these changes
and potential changes are discussed below. The Company cannot predict the
impact, nor give any assurances about the materiality of any potential impact,
that such changes may have on its business or results of operations, nor can it
guarantee that domestic or international regulatory authorities will not raise
material issues regarding its compliance with applicable laws and regulations.
The Federal Communications Commission ("FCC") has jurisdiction over
WilTel's facilities and services to the extent those facilities are used to
provide interstate telecommunications services (services that originate and
terminate in different states) or international telecommunications services.
State regulatory commissions generally have jurisdiction over facilities and
services to the extent the facilities are used in intrastate telecommunications
services. Foreign laws and regulations apply to telecommunications that
originate or terminate in a foreign country. Generally, the FCC and state
commissions do not regulate Internet, video conferencing or certain data
services, although the underlying telecommunications services components of such
offerings may be regulated in some instances.
WilTel's operations also are subject to a variety of environmental,
building, safety, health and other governmental laws and regulations.
Federal Regulation
The Communications Act of 1934. The Communications Act of 1934, as
amended (the "Communications Act") grants the FCC authority to regulate
interstate and foreign communications by wire or radio. The Telecommunications
Act of 1996 (the "1996 Act") establishes a framework for fostering competition
in the provision of local and long distance telecommunications services. WilTel
is regulated by the FCC as a non-dominant carrier and, therefore, is subject to
less comprehensive regulation than dominant carriers under the Communications
Act. WilTel is subject to certain provisions of Title II of the Communications
Act applicable to all common carriers that require WilTel to offer service upon
reasonable request and pursuant to just and reasonable charges and practice, and
prohibit WilTel from unjustly or unreasonably discriminating in its charges or
practices. The FCC has authority to impose more stringent regulatory
requirements on non-dominant carriers. The FCC reviews its rules and regulations
from time to time, and WilTel may be subject to those new or changed rules.
WilTel has obtained authority from the FCC to provide international
services between the U.S. and foreign countries, and has registered with the FCC
as a provider of domestic interstate long distance services. WilTel believes
that it is in material compliance with applicable federal laws and regulations,
but cannot guarantee that the FCC or third parties will not raise issues
regarding its compliance with applicable laws or regulations.
15
Long Distance Regulation. Regulation of other carriers in the
communications industry also may affect WilTel. For example, Section 271 of the
Communications Act had prohibited RBOCs and their respective affiliates from
providing long distance services between so-called Local Access and Transport
Areas ("LATAs") in their region, and between their region and other states,
until they have demonstrated to the FCC, on a state-by-state basis, that they
have satisfied certain procedural and substantive requirements set forth in the
1996 Act. The FCC has granted Section 271 authority to all RBOCs in each of
their in-region states.
In a state where a RBOC has received authority to provide long distance
telecommunications service, Section 272 of the Communications Act requires the
RBOC to maintain a separate affiliate and to comply with certain structural and
operational safeguards for its long distance operations, all of which impose on
RBOCs significant costs related to maintaining separate equipment, employees and
processes. This separate affiliate requirement expires on a state-by-state basis
three years after the RBOC first obtained approval to provide long distance
service in a given state, unless the FCC extends the three-year period. If an
RBOC chooses to provide long distance telecommunications services without a
separate affiliate in a state where the separate affiliate requirement has
expired, the RBOC currently is subject to heightened regulation of its rates for
long distance services. The FCC is considering several options for strengthening
or weakening regulation governing the RBOCs' provision of long distance
telecommunications services without a separate affiliate.
The Section 272 separate subsidiary requirement for two of WilTel's
largest customers, Verizon in New York, Massachusetts, Pennsylvania and Rhode
Island and SBC in Texas, Oklahoma, Kansas, Arkansas and Missouri has expired and
has not been extended by the FCC. WilTel does not expect the FCC to extend the
requirement in any other states as the 3-year period elapses in such states.
While the RBOCs' entry into the long distance market could provide opportunities
for WilTel to sell dark fiber or lease high-volume long distance capacity to the
RBOCs, it could also allow the RBOCs to provide the same services that WilTel
currently provides, services which RBOCs currently purchase from WilTel.
Increased competition from the RBOCs could have an adverse effect on WilTel's
business, as the RBOCs will be able to market integrated local and long distance
services and may enjoy significant competitive advantages. Because RBOCs account
for approximately 75% of WilTel's Network revenues, the RBOC's ability to offer
long distance voice and data services poses risks to WilTel's business in the
future. For information about SBC (Network's largest customer) and its plan to
acquire AT&T and migrate its traffic to AT&T's network, see Item 1,
"Business-Telecommunications" above.
Local Service Regulation. In addition to overseeing the entry of the
RBOCs into the long distance market, the FCC was required, pursuant to the 1996
Act, to establish national rules implementing the local competition provisions
of the 1996 Act. More specifically, the 1996 Act imposed duties on all local
exchange carriers, including incumbent local exchange carriers ("ILECs") and new
entrants (sometimes referred to as competitive local exchange carriers, or
"CLECs") to provide network interconnection, reciprocal compensation, resale,
number portability and access to rights-of-way. Where WilTel provides local
telecommunications services, it must comply with these statutory obligations and
the FCC's implementing rules.
In March 2004, the U.S. Court of Appeals for the District of Columbia
Circuit struck down an FCC rule that required regional telephone companies to
open their networks to competitors at reasonable rates. In response, the FCC
issued interim rules requiring regional local telephone companies to continue
opening their networks to competitors at reasonable rates until the earlier of
such time as the FCC issues permanent rules or September 13, 2005 (with
increased rates and reduced availability effective March 13, 2005). The FCC
released permanent rules on February 3, 2005. As a result, competing telephone
companies will be charged higher rates by local telephone companies to use parts
of their networks on certain routes, or incur costs to purchase and install
their own networks in order to offer local phone service. Although WilTel's
wholesale carrier market segment is not likely to be materially affected by
these actions, its enterprise market segment could experience a short-term cost
disadvantage with competitors who have cheaper access to local telephone company
networks. In addition, certain of WilTel's customers could be significantly
affected by these changes.
16
Access Regulation. Federal regulation affects the cost and thus the
demand for long distance services through regulation of interstate access
charges, which are the local telephone companies' charges for use of their
exchange facilities in originating or terminating interstate transmissions. The
FCC regulates the interstate access rates charged to long distance carriers by
ILECs and CLECs for the local origination and termination of interstate long
distance traffic. Those access rates make up a significant portion of the cost
of providing long distance traffic. Since the 1996 Act, the FCC has restructured
the access charge system, resulting in significant downward changes in access
charge rate levels.
On May 31, 2000, the FCC adopted a proposal submitted by a coalition of
long distance companies and RBOCs, referred to as "CALLS," pursuant to which
ILEC access rates must be decreased in stages over five years. On September 10,
2001, the United States Court of Appeals for the Fifth Circuit upheld most of
the FCC's CALLS order, but remanded for further consideration portions of the
order that created a new universal service fund and that set a factor applied
annually to reduce access rates at a certain pace. The FCC issued an order on
July 10, 2003 on remand readopting the substance of the disputed aspects of the
CALLS order, and the remand order was not appealed.
On April 27, 2001, the FCC issued a ruling regarding the interstate
access charges levied by CLECs on long distance carriers. Effective June 20,
2001, CLEC access charges were required to be reduced over a three-year period
to the level charged by ILECs in the competing area. This reduction in CLEC
access charge rates has resulted in a substantial reduction in the per-minute
rate CLECs charge WilTel for interstate access services.
On April 19, 2001, the FCC adopted a Notice of Proposed Rulemaking
seeking to unify its inter-carrier compensation rules. The FCC proposal seeks to
address disparities in rates for access charges and reciprocal compensation (the
rates that carriers pay each other for completing local calls exchanged between
them). The FCC's proposal seeks comments on a transition to a "bill and keep"
system pursuant to which carriers would not exchange cash compensation, but
would provide call completion services free of charge. Adoption by the FCC of a
unified inter-carrier compensation regime that adopts a "bill and keep" regime
or that otherwise reduces the rates that carriers may charge for access charges
could significantly reduce WilTel's inter-carrier compensation costs and
revenues. Several groups of industry participants, seeking to develop an
industry consensus to present to the FCC, have submitted proposals for broad
reform to the FCC, and on February 10, 2005, the FCC announced the adoption of a
further notice of proposed rulemaking in which it would seek comment on these
various proposals. WilTel is unable to determine at this time the outcome of the
FCC proceeding and the industry effort or the resulting impact, if any, on
WilTel's business.
Voice-over-IP. In a 1998 report to Congress, the FCC suggested, but did
not conclude, that telephone calls using IP could be considered
telecommunications services. The FCC has also been asked to consider the
regulatory implications of such "Voice-over-IP" technology. Certain ILECs have
asked the FCC to rule that certain transmission services, such as calls made
over the Internet, are subject to regulation as telecommunications services
including the assessment of interstate switched access charges and universal
service fund assessments. On February 5, 2003, pulver.com filed a petition for
declaratory ruling that a service offering that uses IP voice communications is
neither telecommunications nor a telecommunications service. On February 19,
2004, the FCC held that the specific "IP-to-IP" service offered by pulver.com is
an interstate information service and is neither telecommunications nor a
telecommunications service.
In a May 2004 ruling, the FCC clarified that whenever traffic originates
and terminates on the public switched telephone network, long distance carriers
(such as WilTel) that carry such traffic must pay access charges, but the FCC
has not yet addressed whether traffic originating on broadband networks is
subject to such charges. RBOCs have attempted to recover unpaid access charges
from long distance carriers who were following business practices not consistent
with the FCC ruling. Although WilTel had been actively seeking clarification
from the FCC concerning this matter, WilTel's policy has been to accrue access
charges in a manner that it believes is consistent with the FCC's ruling. The
FCC's ruling is not expected to have a material impact on WilTel; however,
certain of WilTel's customers and competitors may be adversely affected.
17
On November 12, 2004, the FCC granted the request of Vonage Holdings
Corporation to preempt the Minnesota Public Utility Commission from regulating
Vonage's broadband-originated services as a telecommunications service subject
to full state regulation. WilTel believes that the FCC's ruling provides the FCC
with authority to create uniform rules applicable to Voice-over-IP. The FCC's
Vonage decision has been appealed by several state public utility commissions.
Several other Voice-over-IP petitions have also been filed. During 2004,
both Level 3 Communications and SBC filed petitions seeking FCC rulings on the
regulatory framework for Voice-over-IP related offerings. Other local exchange
carriers have filed similar petitions, and the FCC has requested comments on
developing comprehensive rules to cover Voice-over-IP. Absent FCC action on
these matters, some state public utility commissions and private parties
(through agreements) have begun addressing important issues such as the amount
of compensation companies must pay for termination of Voice-over-IP traffic on
the public switched telephone network. Decisions on the Level 3 and SBC
petitions are expected during the first or second quarter of 2005. As carriers
and their customers migrate to IP and packet-based technologies, the outcome of
such proceedings is likely to affect carrier-carrier and carrier-customer
relationships. WilTel is unable to determine at this time the outcome of any of
these proceedings or the impact, if any, they could have on its business.
However, assuming the same volume of voice minutes, WilTel believes that
revenues and profitability for Voice-over-IP services may be less than
traditional voice transport products.
Universal Service. Pursuant to the 1996 Act, in 1997 the FCC established
a significantly expanded universal service regime to subsidize the cost of
telecommunications services to high-cost areas, to low-income customers, and to
qualifying schools, libraries and rural health care providers. Providers of
interstate and international telecommunications services, and certain other
entities, must pay for these programs by contributing to a Universal Service
Fund (the "Fund"). The rules concerning which services are considered when
determining how much an entity is obligated to contribute to the Fund are
complex; however, many of the services sold by WilTel are included in the
calculation. Current rules require contributors to make quarterly and annual
filings reporting their revenues, and the Universal Service Administrative
Company issues monthly bills for the required contribution amounts, based on a
quarterly contribution factor approved by the FCC. The FCC announced assessments
for the first quarter of 2005 of 10.7% have been increased from 8.7% in the
fourth quarter of 2004. The contribution factor may be higher in future
quarters. A portion of WilTel's gross revenues from the provision of interstate
and international services are subject to these assessments. For the year ended
December 31, 2004, WilTel was assessed approximately $6,600,000 by the Fund.
On December 13, 2002, the FCC issued revised universal service rules and
proposed further changes to the universal service contribution methodology.
Under one of the proposed changes, the FCC would begin assessing contributions
to the Fund based on working telephone numbers and connections to telephone
company customers, as opposed to the existing mechanism that requires
contributions based on end user revenues. The FCC is expected to adopt this
proposal during 2005. Although any FCC changes to the methodology could result
in WilTel paying a larger percentage of its revenues to the Fund, WilTel is
unable to determine what changes will occur and what impact those changes will
have on its business.
WilTel and other contributors to the federal universal service fund may
recover their contributions in any manner that is equitable and
nondiscriminatory, but may not mark up their federal universal service recovery
above the amount of the contribution factor. Carriers may recover their
contribution costs through their end-user rates, or through a line item (stated
as a flat amount or percentage), provided that the line item does not exceed the
total amount associated with the contribution factor. The recovery rules are the
subject of a petition for reconsideration pending before the FCC. The rules also
allow contributors to renegotiate contract terms that prohibit the pass-through
of universal service recovery charges. Unrecovered assessments will increase
WilTel's costs.
18
Broadband Regulation. The FCC to date has treated Internet service
providers as enhanced service providers rather than common carriers. As such,
Internet service providers generally have been exempt from various federal and
state regulations, including the obligation to pay access charges and contribute
directly to universal service funds. On December 20, 2001, the FCC issued a
Notice of Proposed Rulemaking seeking comment on whether ILEC broadband
offerings are telecommunications services subject to Title II jurisdiction or,
as the FCC already has concluded with respect to cable modem service,
information services subject only to Title I jurisdiction. In 2003, the United
States Court of Appeals for the Ninth Circuit partially vacated the FCC's
determination that cable modem service is subject only to Title I jurisdiction,
holding that companies providing cable modem services also offer a
telecommunications service component that is subject to Title II regulation. The
FCC appealed that decision, and the U.S. Supreme Court is scheduled to hear the
case during 2005. In a separate Notice of Proposed Rulemaking released February
15, 2002, the FCC sought comment on issues related to broadband access to the
Internet over domestic wireline facilities, including whether facilities-based
broadband Internet access providers should be required to contribute to support
universal service. The FCC has not addressed either of these Notices of Proposed
Rulemaking and WilTel cannot determine how the U.S. Supreme Court will rule on
the Ninth Circuit decision, and whether such action will impact WilTel's
business.
State Regulation
The Communications Act severely restricts state and local governments
from enforcing any law, rule or legal requirement that prohibits or has the
effect of prohibiting any person from providing any interstate or intrastate
telecommunications service. However, states retain substantial jurisdiction over
intrastate matters, and generally have adopted regulations intended to protect
public safety and welfare, ensure the continued quality of communications
services, and safeguard the rights of consumers. Some states impose assessments
for state universal service programs and for other purposes. To the extent that
WilTel provides intrastate telecommunications services, WilTel is subject to
various state laws and regulations.
Most state public utility and public service commissions require some
form of certificate of authority or registration before offering or providing
intrastate services, including competitive local telecommunications services.
Currently, WilTel or its subsidiary, WilTel Local Network, LLC, hold
authorizations to provide such services, at least to some extent, in all 50
states and the District of Columbia.
In most states, in addition to the requirement to obtain a certificate of
authority, WilTel must request and obtain prior regulatory approval of price
lists or tariffs containing rates, terms and conditions for its regulated
intrastate services. WilTel is required to update or amend these tariffs when it
adjusts its rates or adds new products. WilTel believes that most states do not
regulate its provision of dark fiber. If a state did regulate its provision of
dark fiber, WilTel could be required to provide dark fiber in that state
pursuant to tariffs and at regulated rates.
WilTel is also subject to various reporting and record-keeping
requirements in states in which it is authorized to provide intrastate services.
Many states also require prior approval for transfers of control of certified
providers, corporate reorganizations, acquisitions of telecommunications
operations, assignment of carrier assets, carrier stock offerings and
undertaking of significant debt obligations. States generally retain the right
to sanction a service provider or to condition, modify or revoke certification
if a service provider violates applicable laws or regulations. Fines and other
penalties also may be imposed for such violations. While WilTel believes that it
is substantially in compliance with applicable state laws and regulations that
are material to its operations, it cannot guarantee that state regulatory
authorities or third parties will not raise issues with regard to its
compliance.
State regulatory commissions generally regulate the rates that ILECs
charge for intrastate services, including intrastate access services paid by
providers of intrastate long distance services. WilTel's intrastate services
compete against the regulated rates of these carriers and also utilize certain
ILEC services. State regulatory commissions also regulate the rates ILECs charge
for interconnection of network elements with, and resale of, services by
competitors. State commissions have initiated proceedings that could have the
potential to affect the rates, terms and conditions of intrastate services.
WilTel, through WilTel Local Network, LLC, has entered into or is in the process
of entering into interconnection agreements with various ILECs and the rates,
terms and conditions contained in such agreements will be affected by such state
proceedings.
19
Local Regulation
Some jurisdictions require WilTel to obtain street use and construction
permits and licenses and/or franchises before installing or expanding its
fiber-optic network using municipal rights-of-way. Termination of, or failure by
WilTel to renew, its existing franchise or license agreements could have a
material adverse effect on its operations. In some municipalities where WilTel
has installed or may construct facilities, it is required to pay license or
franchise fees based on a percentage of gross revenue, a flat annual fee or a
per linear foot basis. WilTel cannot guarantee that fees will remain at their
current levels following the expiration of existing franchises. In addition,
WilTel could be at a competitive disadvantage if its competitors do not pay the
same level of fees as it does. The Communications Act requires municipalities to
manage public rights of way in a competitively neutral and non-discriminatory
manner and prohibits the imposition of right-of-way fees as a means of raising
revenue. A considerable amount of litigation has challenged right-of-way fees on
the grounds that such fees violate the Communications Act. The outcome of such
litigation may affect WilTel's costs of operations.
Other U.S. Regulation
WilTel's operations are subject to a variety of federal, state and local
environmental, safety and health laws and governmental regulations. These laws
and regulations govern matters such as the generation, storage, handling, use
and transportation of hazardous materials, the emission and discharge of
hazardous materials into the atmosphere, the emission of electromagnetic
radiation, the protection of wetlands, historic sites and endangered species,
and the health and safety of employees. WilTel also may be subject to
environmental laws requiring the investigation and cleanup of contamination at
sites it owns or operates or at third-party waste disposal sites. Such laws
often impose liability even if the owner or operator did not know of, or was not
responsible for, the contamination.
WilTel owns or operates numerous sites in connection with its operations.
WilTel monitors compliance with environmental, safety and health laws and
regulations and believes it is in material compliance; however, it cannot give
assurances that it has been or will be in complete compliance with these laws
and regulations. WilTel may be subject to fines or other sanctions imposed by
governmental authorities if it fails to obtain certain permits or violates their
respective laws and regulations.
WilTel has ownership interests in and utilizes certain submarine cable
systems for the provision of telecommunications services. WilTel, through its
joint ownership interests, is subject to certain state and federal laws and
regulations governing the construction, maintenance and use of such facilities.
Such laws and regulations may include corridor restrictions, exclusionary zones,
undersea cable fees or right-of-way use fees for submerged lands. Increased
regulation of cable assets or assessments may affect the cost and ultimately the
demand for services provided over such facilities.
Foreign Regulation
The provision of telecommunications services in foreign countries is also
regulated and varies from country to country. Telecommunications carriers are
generally required to obtain permits, licenses or authorizations to initiate or
terminate communications in a country. Many regulatory systems have only
recently faced the issues raised by competition and are still in the process of
development. Although the services WilTel currently provides outside the U.S.
are not currently material, if WilTel expands its foreign operations it will be
subject to substantial regulatory requirements. Foreign telecommunications laws
and regulations are changing and WilTel cannot determine at this time the
impact, if any, that such future regulatory, judicial or legislative activities
may have on its business or operations.
International switched long distance traffic between two countries
historically is exchanged under correspondent agreements between carriers, each
owning network transmission facilities in their respective countries.
Correspondent agreements generally provide for, among other things, the
termination of switched traffic in, and the return of switched traffic to, the
carriers' respective countries at a negotiated accounting rate. Settlement
costs, typically one-half of the accounting rate, are reciprocal fees owed by
one international carrier to another for transporting traffic on its facilities
and terminating that traffic in the other country. The FCC and regulators in
foreign countries may regulate agreements and settlements between U.S. and
foreign carriers.
20
Healthcare Services
Business Description
In September 2003, the Company acquired Symphony for approximately
$36,700,000, including expenses. Established in 1994, Symphony provides
post-acute healthcare services including contract therapy, long-term care
consulting and temporary staffing to skilled nursing facilities, hospitals,
sub-acute care centers, assisted living facilities, schools and other healthcare
providers. Symphony currently operates in 46 states, providing services at
approximately 2,000 locations through its employee workforce of approximately
3,200 part-time and full-time skilled healthcare professionals (excluding
temporary personnel). The businesses owned by Symphony operate under the names
RehabWorks, VTA Management Services, VTA Staffing Services, Symphony Respiratory
Services, NurseWorks and Polaris Group. At December 31, 2004, the Company's
consolidated balance sheet includes total Symphony assets of $65,600,000 and
total Symphony liabilities of $60,200,000 (which are non-recourse to the
Company), resulting in a net investment of $5,400,000.
The principal services offered by Symphony are described below.
o Contract Therapy Services - Physical therapy, occupational
therapy, speech pathology and respiratory therapy services
provided to various health care providers and schools. Services
include compliance and clinical training, recruitment, orientation
and staffing, management information and reimbursement expertise.
o Healthcare Staffing Services - Placement of temporary healthcare
professionals in hospitals and skilled nursing facilities
generally ranging from one day to 13-week assignments.
o Consulting Services - These services assist healthcare providers
in managing Medicare reimbursement to ensure that systems and
procedures are in place to manage costs and cash flow.
When determining how to meet their rehabilitation therapy and healthcare
staffing needs, healthcare providers are faced with an "in-source" or
"outsource" decision, to either manage the rehabilitation therapy unit in-house
or to contract the service to an outside vendor. As healthcare expenditures in
the U.S. have continued to increase, healthcare providers have experienced
increased cost reduction pressures as a result of managed care and the
implementation of prospective payment systems, where fixed fee schedules are set
by the Center for Medicare and Medicaid Services ("CMMS"). Symphony's services
give its customers increased flexibility in managing staffing levels and enables
them to reduce their overall costs by converting a fixed cost into a variable
cost. Contract therapy is available on a full-time, part-time and on-call basis,
and can be customized at each location according to the particular needs of a
facility or patient. Contract therapy services also include full therapy program
management with a full-time program manager who is also a therapist and two to
four professionals trained in physical and occupational therapy or
speech/language pathology. Symphony generally bills its customers either on the
basis of a negotiated patient per diem rate or a negotiated fee schedule based
on the type of service rendered. Symphony is also the largest provider of
therapy services to the Department of Education of New York City.
Symphony's revenues and growth are affected by trends and developments in
healthcare spending, which has been increasing at an accelerated rate over the
past five years. Demographic considerations also affect the amount spent on
healthcare. Due to the increasing life expectancy of Americans, the number of
people aged 65 years or older has been growing and is expected to increase in
the future. These trends, combined with the need for healthcare providers to
find more cost effective means to deliver their services, may encourage
healthcare providers to use the services offered by Symphony and its
competitors.
21
Competition
The contract therapy and healthcare staffing services businesses compete
in national, regional and local markets with full-service staffing companies and
with specialized staffing agencies. The program management services business
competes with companies that may offer one or more of the same services and with
hospitals and skilled nursing facilities that do not choose to outsource these
services. The managed inpatient units and outpatient programs are in highly
competitive markets and compete for patients with other hospitals and skilled
nursing facilities.
There is a significant shortage of skilled healthcare professionals who
provide Symphony's services, and Symphony's revenues are dependent on its
ability to attract, develop and retain qualified therapists and other healthcare
personnel who possess the skills, experience and, as required, licensure
necessary to meet the specified requirements of customers. Symphony competes for
healthcare staffing personnel, with other healthcare companies, as well as
actual and potential customers, some of whom seek to fill positions with either
regular or temporary employees.
Government Regulation
Healthcare providers are subject to a complex array of federal, state and
local regulations which include but are not limited to Medicare and Medicaid
regulations, licensure regulations, fraud and abuse regulations, as well as
regulations regarding the confidentiality and security of health-related
information. If Symphony fails to comply with these laws it can result in civil
penalties, criminal penalties and/or exclusion from participation with programs
such as Medicare and Medicaid. Failure of Symphony's customers to meet
regulatory requirements could have an adverse impact on its business.
Symphony's customers are subject to state licensure and Medicare
certification requirements with respect to their facilities and healthcare
professionals. Symphony is also subject to these requirements when it is the
direct provider of the service. Systems are in place to assure that these
requirements are met before Symphony's healthcare professionals treat patients.
In most instances, customers participate in the Medicare and Medicaid
programs as do certain of Symphony's outpatient therapy facilities. As such,
they are subject to Medicare and Medicaid's regulations regarding quality of
care, qualifications of personnel, adequacy of physical plant, as well as
billing and payment regulations. These regulations are written, published and
administered by the CMMS and are monitored for compliance.
Various federal and state laws prohibit the knowing and willful
submission of false claims or fraudulent claims to obtain payment from Medicare,
Medicaid or other government programs. The federal anti-kickback statute also
prohibits individuals and entities from knowingly and willfully paying,
offering, receiving or soliciting money or anything else of value in order to
induce the referral of patients or to induce a person to purchase, lease, order,
arrange for or recommend services or goods covered by Medicare, Medicaid or
other government healthcare programs.
The Balanced Budget Act of 1997 mandated the phase-in of a Medicare Part
A prospective payment system for skilled nursing facilities and units based on
the category of patient care under resource utilization group classifications
established by the CMMS. All of the skilled nursing units to which we provide
management services are now fully phased in under the resource utilization group
system for skilled nursing facilities. The proposed 2006 federal budget includes
a provision to refine the resource utilization group system to more
appropriately account for certain high cost cases, but no assurance can be given
that such changes will be implemented. Under the Medicare Part B payment system,
reimbursement for outpatient therapy services is based on the lesser of the
provider's actual charge for such services or the applicable Medicare physician
fee schedule amount also established by the CMMS. As part of the Balanced Budget
Act of 1997, the outpatient therapy benefit was capped at $1,590 per beneficiary
per year, but the implementation of the cap has been delayed a number of times
through legislation. Most recently, a two year moratorium expiring on December
31, 2005, was placed on implementation of the cap. Absent specific action by
Congress the moratorium will expire and the benefit cap will go into place on
January 1, 2006.
22
The Health Insurance Portability and Accountability Act of 1996 is
designed to improve efficiency in healthcare delivery by standardizing
electronic data interchange and by protecting the confidentiality and security
of an individual's health data by setting and enforcing national standards of
practice. Virtually all healthcare providers are affected by the law, which
consists of three primary areas, standards for electronic transactions, privacy
and security. The privacy rule and the standards for electronic transactions are
currently effective and the security rule is scheduled to become effective on
April 21, 2005. Symphony is in compliance with the privacy and electronic
transmission provisions and believes that it will be in compliance with the
security rule.
Manufacturing
Through its plastics division, the Company manufactures and markets
lightweight plastic netting used for a variety of purposes including, among
other things, building and construction, erosion control, agriculture,
packaging, carpet padding, filtration and consumer products. The products are
primarily used to add strength to other materials or act as barriers, such as
warning fences and crop protection from birds. The plastics division is a market
leader in netting products used in carpet cushion, erosion control, nonwoven
reinforcement and crop protection. Certain of the division's products are
proprietary, protected by patents and/or trade secrets. It markets its products
both domestically and internationally, with approximately 16% of its 2004
revenues generated by customers in Europe, Latin America, Japan and Australia.
Products are sold primarily through an employee sales force, located in the
United States and Europe. Manufacturing revenues were $64,100,000, $53,300,000
and $50,700,000 for the years ended December 31, 2004, 2003 and 2002,
respectively. At December 31, 2004, the Company's consolidated balance sheet
includes total manufacturing assets of $50,400,000 and total manufacturing
liabilities of $21,100,000, resulting in a net investment of $29,300,000.
New product development focuses on market niches where the division's
proprietary technology and expertise can lead to sustainable competitive
economic advantages. Historically, this targeted product development generally
has been carried out in partnership with a prospective customer or industry
where the value of the product has been recognized. The plastics division has
also begun focusing on developing products which provide an upgrade to a current
product used by an existing customer. Over the last several years, the plastics
division has spent approximately 2% to 5% of annual sales on the development and
marketing of new products and new applications of existing products.
The plastics division is subject to domestic and international
competition, generally on the basis of price, service and quality. Additionally,
certain products are dependent on cyclical industries, including the
construction industry. The cost of the principal raw material used in its
products, polypropylene, has increased by approximately 80% since the beginning
of 2004. High oil and natural gas prices along with high capacity utilization in
the polypropylene industry are expected to keep raw material costs higher than
historical levels for the next two years. The division was able to raise prices
to its customers during 2004 to offset the increase in polypropylene costs.
The plastics division currently has excess manufacturing capacity,
principally in its Belgium facility which became operational in the third
quarter of 2001. Utilization of this capacity has taken longer than anticipated
primarily due to the loss of a major customer for whom the facility was expected
to produce products. A new general manager was hired at the facility in 2004 to
develop and implement marketing and sales initiatives directed at generating
revenue growth. Operating results at the facility have improved during 2004 as
sales grew 20% compared to 2003 and the business achieved positive cash flow.
New customer acquisitions must continue in order for the facility to reach
profitability.
The Company holds patents on certain improvements to the basic
manufacturing processes it uses and on applications thereof. The Company
believes that the expiration of these patents, individually or in the aggregate,
is unlikely to have a material effect on the plastics division.
As mentioned above, in February 2005 the Company acquired the assets of
NSW for approximately $28,000,000, thereby increasing its mix of products and
customer base. NSW has a manufacturing and distribution facility in Roanoke,
Virginia, and for its year ended December 31, 2004 generated annual sales of
approximately $20,000,000. Although the Company plans to integrate certain of
NSW's operating activities into its own, principally in the administration and
raw materials purchasing areas, NSW's manufacturing facility will continue as a
stand-alone operation. Products manufactured by NSW include produce and
packaging nets, header label bags, case liners and heavy weight nets for
drainage and erosion control purposes.
23
Banking and Lending
Business Description
Over the past few years, the Company has been shrinking its banking and
lending operations. Historically, this segment made collateralized consumer
loans consisting principally of personal automobile instalment loans to
individuals who had difficulty obtaining credit. The Company's other consumer
lending programs primarily consisted of marine, recreational vehicle, motorcycle
and elective surgery loans. These lending activities were conducted through
American Investment Bank, N.A. ("AIB"), a national bank subsidiary, and American
Investment Financial, a Utah industrial loan corporation which merged into AIB
in 2004.
The segment's current operating activities are concentrated on
maximizing returns on its investment portfolio, collecting and servicing its
remaining loan portfolios and discharging deposit liabilities as they come due.
In September 2001, the Company stopped originating subprime automobile loans as
a result of increasing loss experience and the increasingly difficult
competitive environment. In January 2003, the Company stopped originating all
consumer loans. In May 2004, the Company sold its subprime automobile and
collateralized consumer loan portfolios, which represented 97% of banking and
lending's total outstanding loans (net of unearned finance charges). The Company
received aggregate cash proceeds of $149,000,000 and reported a pre-tax gain of
$8,700,000, which is reflected in investment and other income. In September
2004, the Company sold certain loan portfolios that had been substantially
written-off and reported a pre-tax gain of $7,600,000, which is reflected in
investment and other income.
Certain information with respect to the Company's banking and lending
segment is as follows for the years ended December 31, 2004, 2003 and 2002
(dollars in thousands):
2004 2003 2002
---- ---- ----
Average loans outstanding $57,097 $282,986 $440,810
Interest income earned on loans $10,037 $ 53,944 $ 86,018
Average loan yield 17.6% 19.1% 19.5%
Average deposits outstanding $73,260 $251,031 $454,497
Interest expense on non-demand deposits $ 2,394 $ 8,553 $ 18,035
Average rate on non-demand deposits 3.3% 3.4% 3.9%
Net yield on interest-bearing assets 5.3% 12.1% 11.5%
Investments held by the banking and lending segment are primarily U.S.
Government agencies and mortgage-back securities.
24
It is the Company's policy to charge to income an allowance for losses
which, based upon management's analysis of numerous factors, including current
economic trends, aging of the loan portfolio, historical loss experience and
collateral value, is deemed adequate to cover probable losses on outstanding
loans. At December 31, 2004, the allowance for loan losses for the Company's
entire loan portfolio was $950,000 or 22% of the net outstanding loans, compared
to $24,200,000 or 11.8% of net outstanding loans at December 31, 2003.
Government Regulation
The Company's principal banking and lending operations are subject to
supervision by federal authorities, as well as federal regulation pursuant to
the Federal Consumer Credit Protection Act, the Truth in Lending Act, the Equal
Credit Opportunity Act, the Right to Financial Privacy Act, the Community
Reinvestment Act, the Fair Credit Reporting Act and regulations promulgated by
the Federal Trade Commission and the Board of Governors of the Federal Reserve
System. The Company's banking operations are subject to federal regulation and
supervision by, among others, the Office of the Comptroller of the Currency (the
"OCC") and the FDIC.
In 2003, AIB entered into a formal agreement with the OCC, pursuant to
which the OCC approved AIB's strategic plan for exiting its existing lending
businesses. AIB also agreed to initiate a regulatory process by January 31,
2005, which would result in the eventual surrender of its national bank charter.
In November 2004, AIB submitted an application to the state of Utah to convert
its current national charter to a Utah state commercial bank charter. AIB is not
able to surrender its national bank charter while it still has deposits
outstanding, unless it is able to convert its charter to a Utah state commercial
bank charter. However, in January 2005 the state of Utah notified AIB that it
was suspending the application to convert AIB's charter until such time as AIB
has the operational structure in place that is necessary to begin loan
originations. AIB does not intend to make these changes. In February 2005, the
OCC denied AIB's prior request to extend the deadline to begin the regulatory
process to surrender the national charter, and required AIB to begin the
regulatory process to surrender the national charter within 30 days from the
date of the OCC's denial. Since AIB's application to convert the charter was not
approved, and since the OCC did not approve AIB's request for an extension, AIB
will file a plan with the OCC that will ultimately result in the surrender of
its national bank charter. No assurance can be given that the OCC will approve
AIB's plan of voluntary liquidation or that it will not take other adverse
regulatory action.
The Competitive Equality Banking Act of 1987 ("CEBA") places certain
restrictions on the operations of AIB and restricts further acquisitions of
banks and savings institutions by the Company.
25
Domestic Real Estate
At December 31, 2004, the Company's domestic real estate assets had a
book value of $131,200,000. The real estate operations include a mixture of
commercial properties, residential land development projects and other
unimproved land, all in various stages of development and all available for
sale. The Company's largest domestic real estate investment consists of a 90%
interest in 8 acres of unimproved land in Washington, D.C., which was acquired
in September 2003 and has a book value of $57,600,000 at December 31, 2004. The
land is zoned for a minimum of 2,000,000 square feet of commercial office space
that the Company intends to develop in phases once acceptable tenants or
purchasers are identified. The Company owns a 716-room hotel located on Waikiki
Beach in Hawaii that has a book value of $39,400,000 at December 31, 2004. The
hotel was fully renovated during 2001 and 2002, and for 2004 had an occupancy
rate of approximately 66% and a net average daily room rate of $109.05. The
Company secured non-recourse financing for these two projects, which aggregated
$42,400,000 as of December 31, 2004.
The Company owns 30% of the outstanding common stock of HomeFed. In
addition, as a result of a 1998 distribution to all of the Company's
shareholders, approximately 9.4% and 9.5% of HomeFed is owned by the Company's
Chairman and President, respectively. HomeFed is currently engaged, directly and
through subsidiaries, in the investment in and development of residential real
estate projects in the State of California. Its current development projects
consist of two master-planned communities located in San Diego County,
California: San Elijo Hills, which it purchased from the Company in 2002, and a
portion of the larger Otay Ranch planning area. The Company accounts for its
investment in HomeFed under the equity method of accounting. At December 31,
2004 its investment had a carrying value of $39,500,000 which is included in
investments in associated companies. HomeFed is a public company traded
on the NASD OTC Bulletin Board (Symbol: HOFD).
Certain of the Company's other real estate investments and their
respective carrying values as of December 31, 2004 include: approximately 88
acres of land located in Myrtle Beach, South Carolina, which is fully entitled
for a large scale mixed-use development of various residential and commercial
space ($12,900,000); and an operating shopping center on Long Island, New York
that has 60,000 square feet of retail space ($7,100,000).
The real estate development industry is subject to substantial
environmental, building, construction, zoning and real estate regulations that
are imposed by various federal, state and local authorities. In order to develop
its properties, the Company must obtain the approval of numerous governmental
agencies regarding such matters as permitted land uses, density, the
installation of utility services (such as water, sewer, gas, electric, telephone
and cable television) and the dedication of acreage for various community
purposes. Furthermore, changes in prevailing local circumstances or applicable
laws may require additional approvals or modifications of approvals previously
obtained. Delays in obtaining required approvals and authorizations could
adversely affect the profitability of the Company's projects.
Other Operations
Wineries
The Company owns two wineries, Pine Ridge Winery in Napa Valley,
California and Archery Summit in the Willamette Valley of Oregon. Pine Ridge,
which was acquired in 1991, has been conducting operations since 1978, while the
Company started Archery Summit in 1993. Since acquisition, the Company's
investment in winery operations has grown, principally to fund the acquisition
of land for vineyard development and to increase production capacity and storage
facilities at both of the wineries. It can take up to five years for a new
vineyard property to reach full production and, depending upon the varietal
produced, up to three years after grape harvest before the wine can be sold. The
Company controls 224 acres of vineyards in the Napa Valley, California and 115
acres of vineyards in the Willamette Valley of Oregon, substantially all of
which are owned and producing grapes. The Company believes that its vineyards
are located in some of the most highly regarded appellations of the Napa Valley.
At December 31, 2004, the Company's combined net investment in these wineries
was $58,000,000. During 2004, the wineries sold approximately 63,600 9-liter
equivalent cases of wine generating wine revenues of $13,200,000.
These wineries primarily produce and sell wines in the luxury segment of
the premium table wine market; however, approximately 7% of the wineries' wine
revenues and 19% of case sales were derived from a wine that is not in the
luxury segment and is made from purchased grapes. The Company's wines are
primarily sold to distributors, who then sell to retailers and restaurants. The
distributors used by the Company also offer premium table wines of other
companies that directly compete with the Company's products. As permitted under
federal and local regulations, the wineries have also been placing increasing
emphasis on sales direct to consumers, which they are able to do through the
internet, wine clubs and at the wineries' tasting rooms. During 2004, direct
sales to consumers represented 21% of case sales and 41% of wine revenues. Sales
of the Company's wines in California and Oregon (excluding direct sales to
consumers) amounted to approximately 11% of 2004 wine revenues.
26
The luxury segment of the wine industry is intensely competitive. The
Company's wines compete with small and large producers in the U.S., as well as
with imported wines. Demand for wine in the luxury market segment can rise and
fall with general economic conditions, and is also significantly affected by
available supply. At present, there is a worldwide oversupply of luxury wine
which may last for a few years. The demand for the Company's wines is also
affected by the ratings given the Company's wines in industry publications.
During the past year, ratings for some of the Company's wines have increased or
stayed substantially the same while ratings for other varietals have declined.
Although future ratings are impossible to predict, the Company would not
normally expect that all of its wines would be similarly rated at the same time.
In the past year wine sales have declined and inventory levels of the
Company's wines held by the Company and its distributors have grown, which
resulted in the need to hold, or for certain varietals reduce prices. In
particular, Pine Ridge has been producing too much Merlot for its historical
sales volume, and it expects to reduce future production through re-budding and
re-planting activities. The Company's wineries have also been focused on
improving wine quality. Wine quality improvements are principally being made by
reducing the amount of grape clusters grown on each grapevine (resulting in
yield reduction) to further concentrate flavor, and investing in new winemaking
equipment. Luxury wines available for sale in any given year are also dependent
upon harvest yields of earlier periods, which can fluctuate from harvest to
harvest depending on weather patterns, insects and other non-controllable
circumstances.
Certain of the wineries' production, sales and distribution activities
are subject to regulation by agencies of both federal and state governments.
There is currently a case pending before the U.S. Supreme Court concerning
interstate wine shipments that could change the ability of wineries to sell wine
directly to consumers in various states. The Company is unable to predict the
eventual outcome of this litigation.
MK Resources
The Company has a 72.1% interest in MK Resources, whose principal
subsidiary, Cobre Las Cruces, S.A., a Spanish company, holds the exploration and
mineral rights to the Las Cruces copper deposit in the Pyrite Belt of Spain.
During 2003, a feasibility study for the project was prepared by DMT-Montan
Consulting GmbH and Outokumpu Technology Group, which incorporates the
requirements of various local regulatory authorities. The feasibility study was
reviewed by Pincock, Allen & Holt, an independent engineering company, and
includes a proven and probable ore reserve calculation prepared by DMT. Pincock,
Allen & Holt made minor adjustments to the ore reserve calculations in
connection with its review. Including these adjustments, proven and probable
reserves are approximately 16 million metric tons of copper ore at an average
grade of 6.62% copper. As of December 31, 2004, the carrying value of the
Company's investment in mining properties, plant and mine development was
$85,400,000 substantially all of which related to Cobre Las Cruces.
Based on the study, the capital costs to build the project are estimated
at 281 million euros ($372,000,000 at exchange rates in effect on March 4,
2005), including working capital, land purchases, and contingencies, but
excluding reclamation bonding requirements, inflation, interest during
construction, cost overruns and other financing costs. Cash operating costs per
pound of copper produced are expected to average 0.33 euros per pound ($.44 per
pound) of copper produced. The project's capital and operating costs will be
paid for in euros, while copper revenues during the life of the mine will be
based on the U.S. dollar. The appreciation of the euro against the U.S. dollar
during the past few years has significantly increased the U.S. dollar cost to
build the project; however, the price of copper in U.S. dollars has also
increased significantly, which would offset the increase in capital costs.
However, there can be no assurance that the relationship between the U.S. dollar
price of copper and the euro will stay the same in the future.
Development of the Las Cruces project is subject to obtaining required
permits, obtaining both debt and equity financing for the project, engineering
and construction. Environmental approval of the project has been obtained from
the Spanish and Andalusian government agencies. The mining concession was
received during 2003, and the four principal water permits that are required
were received during 2003 and 2004. The approvals, permits and concessions that
have been received to date are significant to the successful development of the
project; however, additional licenses and permits will have to be obtained.
Cobre Las Cruces has filed applications with the appropriate regulatory
authorities seeking approval for certain of these matters, while others cannot
be filed until additional engineering work or other steps are completed. Cobre
Las Cruces has also been granted government subsidies of 47.5 million euros
($62,900,000); however, the grants require it to make certain capital
expenditures by March 27, 2005, a deadline that it will not be able to meet
principally because of delays in obtaining permits. Cobre Las Cruces has filed a
request to further extend the deadline, but has been informed that the
government will not act on the extension request prior to the current
expiration. Although MK Resources believes that the extension will be granted,
no assurance can be given that an extension will actually be received. A loss of
the subsidies would adversely impact the economic viability of the project.
27
To date, the Company has been the sole source of funding for the Las
Cruces project. The amount of equity capital and third party financing that can
be obtained for the project and its related cost will be significantly affected
by the assessment of potential investors and lenders of the current and expected
future market price of copper, as well as current market conditions for this
type of investment. MK Resources has not yet determined whether the debt
financing for the project will be denominated in euros or dollars or some
combination of both. During 2004, MK Resources was unsuccessful in raising
equity capital for the project, due to unfavorable market conditions at the
time. Assuming required permits and financing are obtained in a timely manner,
MK Resources anticipates that final design will begin in 2005, followed by
construction and mine development thereafter, with copper production to begin
during 2007. Although MK Resources believes the necessary permitting and
financing will be obtained, no assurances can be given that MK Resources will be
successful, or if successful, when permitting and financing will be obtained.
Further, there may be other political and economic circumstances that could
prevent or delay development of Las Cruces.
Other Investments
In 2004, the Company invested $75,000,000 in INTL Consilium Emerging
Market Absolute Return Fund, LLC ("INTL"), a limited liability company that is
invested in a master fund which primarily invests in emerging markets debt and
equity securities. INTL and the master fund are managed and controlled by an
investment manager who has full discretion over investment and operating
decisions. Under GAAP, INTL is considered a variable interest entity and the
Company is the primary beneficiary; as a result, the Company accounts for its
investment in INTL as a consolidated subsidiary. INTL plans to sell additional
membership interests in the future, which if accomplished could result in the
Company no longer accounting for INTL as a consolidated subsidiary. The Company
can generally withdraw its capital account interest upon 90 days notice, subject
to the manager's ability to liquidate security positions in an orderly manner.
At December 31, 2004, INTL had total assets of $79,600,000, which are reflected
as investments in the Company's consolidated balance sheet, and its liabilities
were not material. For the year ended December 31, 2004, the Company recorded
$2,200,000 of pre-tax income relating to INTL. The Company has included INTL in
its Corporate segment.
In December 2003, the Company purchased all of the debt obligations under
the senior secured credit facility of ATX Communications, Inc. and certain of
its affiliates (collectively "ATX") for $25,000,000, and also entered into an
amendment to the facility pursuant to which the Company agreed to refrain from
exercising certain of its rights under the facility, subject to certain
conditions. ATX is an integrated communications provider that offers local
exchange carrier and inter-exchange carrier telephone, Internet, high-speed data
and other communications services to business and residential customers in
targeted markets throughout the Mid-Atlantic and Midwest regions of the U.S. For
the year ended December 31, 2004, ATX reported total revenues of approximately
$251,000,000.
As contemplated at the time of the Company's purchase, in January 2004,
ATX commenced a voluntary Chapter 11 case in order to reorganize its financial
affairs. During 2004, the Company provided debtor-in-possession financing to ATX
of $5,000,000. This financing is secured by liens on substantially all of ATX's
assets, and is expected to be repaid upon ATX's emergence from bankruptcy. In
January 2005, ATX filed its First Amended Joint Plan of Reorganization (the
"Plan") and related disclosure statement. The Plan was filed after agreements
were reached with major stakeholders and/or the representatives of major
stakeholders in the bankruptcy case. The Plan contemplates that the Company will
convert its current investment in the ATX credit facility into 95% of the new
common stock of the reorganized ATX and a new $25,000,000 senior secured note
which bears interest at 10%. In addition, the Company will provide up to
$25,000,000 of exit financing to ATX to fund bankruptcy related payments and
working capital requirements, which includes the repayment of the Company's
$5,000,000 debtor-in-possession financing. The Plan is subject to the approval
of the bankruptcy court and creditors. Assuming that ATX is reorganized as
contemplated in the Plan, the Company will consolidate ATX as of the date the
Plan becomes effective.
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The Company has an investment in Berkadia, an entity jointly owned by the
Company and Berkshire Hathaway Inc. ("Berkshire"). In 2001, Berkadia lent
$5,600,000,000 on a senior secured basis to FI